The Limitations of Internal Models and the Supervisory Review Process

Paolo Cadoni and Christian Kerfriden

To paraphrase the famous quote by George Box, “all models are wrong, but some are useful”,¹¹ For further details, see Box (2007). no matter how much effort and skilled resources are dedicated to the development and implementation of an internal model, it will still suffer from limitations. This is not necessarily an issue: a model may have limitations, but it can still be appropriate. However, ignoring model limitations will certainly lead to problems in the future. Acknowledging promptly the internal model limitations within the firm allows the organisation to monitor their materiality and plan for corrective actions to improve, where possible, the functioning of the model.

This chapter will introduce a paradigm to deal with internal model’s limitations, providing an illustration of the typical sources of limitations and stresses, and the importance of a good governance framework to identify potential issues and manage them appropriately. It will examine the ongoing monitoring of internal model performance and, more specifically, highlight that while both firms and supervisory authorities are working to prepare and review the internal model’s pre-application and application